Report Warns of Risks in Correspondent Banking Shrinkage

In a file photo, an employee checks U.S. dollar bank-notes at a bank in Hanoi, Vietnam.
Photo:
Reuters

More work is needed to address the persistent drop in the number of correspondent banking relationships and the risks associated with the trend, according to a report by the Financial Stability Board.

An inability to make international payments hinders businesses' ability to settle trade deals, causes financial isolation in certain jurisdictions, and potentially drives some flows into a shadow banking system. This poses a threat to the stability and integrity of the financial system, said the FSB in a report Tuesday, prepared for the Group of 20 meeting of world leaders later this week in Hamburg, Germany.

The number of active correspondent banking relationships dropped by 6% across all currencies between 2011 and 2016, with those for the U.S. dollar and the euro falling approximately 15% in the period, according to data provided to FSB by the Society for Worldwide Interbank Financial Telecommunications, or Swift. The overall downward trend was observed in most regions, with Eastern Europe registering the sharpest fall of 16%, followed by the remainder of Europe, at 15%, Oceania at 12%, and Central and South America at 8%. In part, the drop in correspondent banks in Europe is explained by consolidation in the banking sector.

Large banks in the U.S. and Europe are severing or curtailing their business relationships with remittance companies and smaller local banks in certain regions of the world in a practice known as "de-risking," which started in the mid-2000s on the back of tighter rules on anti-money laundering and terrorism financing. Those rules raised compliance costs at a time when banks were also being required to have high liquidity, eating into the profitability of certain business lines.

But the decline in correspondent banking relationships hasn’t translated in less money flowing across the world. An increase in the use of intermediaries to connect two banks shows the lengthening of payment chains. In a survey of over 300 banks in nearly 50 countries, the FSB also found a growing dependency on fewer correspondent banks, which it identified as a potential vulnerability for the global payment systems.

Around 45% of the banks in the survey said they rely on two or fewer correspondents for more than 75% of the value of wire transfers sent or received as of June 2016. “These were mostly small and medium banks in terms of their assets, and were more vulnerable to restrictions of [correspondent banking relationships],” the report said. In the Caribbean and Latin America, more than 50% of banks reported using two or fewer correspondent banks, it said.

The FSB, which sets global standards and makes recommendations to national authorities, said that some progress has been made from its plan devised in November 2015 to address the decline in correspondent banking relationships. Besides measuring the extent of the drop in these relationships, the plan also aimed to clarify regulatory expectations, help smaller countries to build and communicate their efforts to tackle money laundering, and to strengthen due diligence tools by correspondent banks and reduce costs of implementation.

The report recommends that more work is needed to manage the risks associated with the trend of declining correspondent banking relationships. This work will include the release later this year of a guidance paper on a framework for information sharing within private banks. The FSB also endorses continued support for the strengthening of anti-money laundering and counter-terrorism finance screening where that is deficient, and calls on national regulators on setting out their expectations of compliance standards to help local banks achieve compliance.

Write to Mara Lemos Stein at mara.lemos-stein@wsj.com. Follow her on Twitter at @LikelyMara